What kind of recovery?

In: Uncategorized

13 Nov 2013

My latest Fund Strategy cover story, published today, looks at the discussion of the British economic recovery. The related graphs and a timeline are available here. Tomorrow I will publish the related box that looks at the discussion of rebalancing.

After several years of economic pain the UK economy appears to be enjoying a recovery. This year it has seen three consecutive quarters of GDP growth with a provisional estimate of a 0.8% jump for the third quarter. Nor is the expansion restricted to one or two sectors. All of the main industrial groupings have moved upwards in the past two quarters.

However, looking at the question from a longer-term perspective, since the onset of the economic downturn in 2008 suggests proclamations of recovery should be more guarded. A study by the National Institute of Economic and Social Research, an independent research institute, suggests it is taking longer for Britain to return to its peak than in the aftermath of previous recessions. Despite all the talk of recovery the level of output is still 2.5% below that in early 2008.

Before probing this question more deeply it is necessary to consider what exactly is meant be recovery. If it simply means upward movement in GDP then it started in mid-2009 and it is certainly clear this year. If, on the other hand, it means a return to its previous peak that could easily be more than a year off. Whether the UK has entered a recovery by yet another definition, a return to its trend rate of growth, is open to debate. In October the average forecast for GDP growth was 1.4% for 2013 and 2.2% for 2014.

But even on the level of GDP figures identifying a recovery is not as straightforward as it might first seem. Andrew Milligan, the head of global strategy at Standard Life Investments, says the oil sector should arguably be excluded from the numbers if the trend is to be identified accurately. This is because supplies of oil and natural gas from the North Sea are suffering a sharp and steady decline. He says there is also a case for excluding construction as it is such a cyclical sector.

For the purposes of this article the focus will not just be on whether GDP is moving upwards but on whether the expansion can be durable. Is Britain simply experiencing a cyclical spurt in growth or is there a stronger dynamic at work?

This is similar to what Azad Zangana, a European economist at Schroders, calls a “fundamental recovery”. For him this constitutes: “Improvement in productivity and improvement in international competitiveness as well, which would eventually lead to more investment and better trend growth”

Among economists the main differences on this question are not so much on the facts but on how they should be interpreted. There is a broad consensus that much of the growth apparent so far relates to what could be called the demand side of the economy. This is evident from such indicators as consumer sentiment, house prices and mortgage renewals. On the other hand, there is no clear upward trend in the supply side, in areas such as investment and productivity.

The debate centres on the relationship between the two sides of the economy. Optimists tend to argue that positive signs on the demand side are likely to spark growth on the supply side. Pessimists, in contrast, typically argue that any improvement in the demand side could fizzle out if the productive economy is not revitalised.

This article will consider the two sides of this debate. First, it will look more closely at the claim that the UK is in the early stages of a demand-led recovery. Next it will look more closely at the weaknesses on the supply side of the economy. In conclusion, it will examine if of balance can be found between the two sides of this story.

A demand-led recovery

Many, although not all, of the signs of recovery identified by the optimists relate to what could broadly be called the demand side of the economy. Another way of putting this is that they relate more to consumption than to production.

The optimists do not deny production has some importance. Their argument typically is that more confidence and stronger domestic demand should pave the way for a more broad-based recovery.

Kerry Craig, a global market strategist at JP Morgan Asset Management, says: “How people feel about the economy is a much better indicator of the recovery than just simply looking at the down the line economic data.”

From his perspective the recovery has been evident for the last six to eight months. “We are in the early stages of what is looking like a pretty sustainable recovery,” he says.

Take, for example, the Nationwide Building Society’s house price index. In real terms, when adjusted for inflation, this peaked in the third quarter of 2007 before trending downwards for over four years. But in the third quarter of 2013 prices reached their highest value in real terms since the final quarter of 2011.

Of course there are strong regional disparities with London and the South East outperforming other areas. But this can be taken as a sign that the recovery is uneven rather than that the “animal spirits” of business and consumer confidence are missing.

Critics counter that government schemes, such as Funding for Lending, have helped to buoy up house prices. Nor is there a boom in house building. The construction of new houses, especially in the South-east, remains limited. From this perspective the UK could be experiencing a smaller scale version of the credit-fuelled boom that preceded the recession rather than a fundamental recovery.

Consumer confidence itself can be measured directly in opinion polls. For instance, the GfK Consumer Confidence Index rose for five straight months from April to September this year before dipping in October.

A similar trend is apparent in surveys of business confidence. For example, the CBI Industrial Trends survey, based on the opinions of manufacturers, showed optimism grow at its fastest rate since April 2010. The third quarter survey of chief financial officers by Deloitte showed a similarly upbeat mood with their perception of macro and financial risk hitting three year lows. For the bulls such results are a sign that things are likely to improve further.

But possible signs of an economic recovery are not only apparent in confidence indicators. For example, the chancellor has stated the employment levels are at their highest level ever. This is true although perhaps misleading as the proportion of people with jobs, as opposed to the number, is lower than before the 2008-09 crisis. Nevertheless the unemployment rate, while relatively high, might be expected to be even higher given the longevity of the economic downturn.

Perhaps the most surprising indicator of recovery is the performance of the car sector and transport equipment more generally. Figures from the Society of Motor Manufacturers and Traders, an industry trade body, show strong domestic demand for British cars with figures for September 9.9% up on the same month in 2012. Attractive financial packages have helped contribute to this surge although business confidence is also often identified as a factor.

Supply-side weaknesses

The main weaknesses in the economy relate to the supply side or the productive sphere. In particular investment and productivity growth are stagnant (see graphs). It is hard to imagine a durable recovery without an improvement in these two key measures.

Business investment is key since it typically feeds through into future growth. High investment in a firm essentially represents a decision to pursue corporate expansion. Yet business investment has been flat in recent quarters and it is substantially below the level in the first quarter of 2007. “Unless business investment picks up then sooner or later the current growth will fade,” says Schroders’ Zangana.

Productivity is at root a way of measuring how efficient a firm produces its goods or services. It can be measured in terms of output per worker or output per hour. The second measure shows an improvement over 2013 but no clear upward trend over the longer term.

Economists typically accept that such figures are weak at present but are hopeful that they are likely to improve. Jens Larsen, the chief European economist at RBC Capital Markets, says: “We are recovering now. It is probably mostly a recovery in demand. The question is whether we are going to see the supply side, potential output, follow on.”

He concedes that business investment is weak but argues that “it is likely to pick up as output recovers”. From this perspective investment is likely to follow a recovery in demand rather than drive the improving economy.

Capital Economics, an economic consultancy, recently argued in its UK Quarterly Review for the fourth quarter that it is churlish to complain that signs of recovery are more evident in the sphere of consumption.

“It is perhaps worth starting by making the simple but important point that, after five years of recession and stagnation, some growth – whatever is driving it – is better than no growth.

“After all, what starts as the ‘wrong’ sort of growth could be the trigger for a shift into the ‘right’ sort. A recovery that starts off concentrated in one sector could spur confidence, employment and investment across all parts of the economy, kicking off a virtuous circle that ends up in more broad-balanced growth.”

Samuel Tombs, a UK economist at the group, also makes the point that “the recovery has become much broader based over the last few months”. He acknowledges that at the start of the year the focus was on household spending but points out manufacturing and construction have done well in recent months. “There is still not much of a recovery in business investment but that takes time to come through,” he says.

Conclusion: Finding a balance

Despite the heated discussion on the prospects for Britain’s economic recovery there is no substantial disagreement on the facts. It is widely accepted that most, although not all, of the signs of recovery lie on the demand side. The recovery is typically seen as being driven by domestic consumption rather than by business investment or exports.

The key difference lies in how the relationship between supply and demand are understood. More optimistic commentators tend to argue that strong demand is sooner or later likely to translate into sustained growth. Pessimists, in contrast, tend to maintain that any growth in demand is likely to fizzle out if not matched by improvements in investment and production.

There is also a broader debate to be had about what kind of growth can reasonably be expected of the British economy. Has it entered a “new normal” where growth expectations should be muted from here onwards? Or is it realistic to hope for a renaissance in growth if the right conditions are put in place? That is a discussion for another day.